Loan pricing under Basel capital requirements

We analyze the loan pricing implications of the reform of bank capital regulation known as Basel II. We consider a perfectly competitive market for business loans where, as in the model underlying the internal ratings based (IRB) approach of Basel II, a single risk factor explains the correlation in defaults across firms. Our loan pricing equation implies that low risk firms will achieve reductions in their loan rates by borrowing from banks adopting the IRB approach, while high risk firms will avoid increases in their loan rates by borrowing from banks that adopt the less risk-sensitive standardized approach of Basel II. We also show that only a very high social cost of bank failure might justify the proposed IRB capital charges, partly because the net interest income from performing loans is not counted as a buffer against credit losses. A net interest income correction for IRB capital requirements is proposed.     

The management of interest rate risk during the crisis: Evidence from Italian banks

We use a unique dataset to analyze how Italian banking groups managed their exposure to interest rate risk during the recent financial crisis. First of all, we document that on average the interest rate risk exposure – measured by duration gap approach – has been limited and well below the alert level enforced by regulators. Second, our econometric results indicate a relation of substitutability between banks’ on-balance-sheet interest rate risk and their use of interest rate derivatives suggesting that banks used these two instruments to curb their overall interest rate risk exposure in case of an increase in interest rates. Furthermore, we also find robust evidence of a negative correlation between banks’ interest rate risk and liquidity risk.     

Pricing CDS spreads with Credit Valuation Adjustment using a mixture copula

Credit derivatives pricing models before Basel III ignored losses in market value stemming from higher probability of counterparty default. We propose a general credit derivatives pricing model to evaluate a Credit Default Swap (CDS) with counterparty risk, including the Credit Valuation Adjustment (CVA) in order to optimize the economic capital allocation. We work from the model proposed by Luciano (2003, Working Paper, International Center of Economic Research) and the general pricing representation established by Sorensen and Bollier (Financial Analysts Journal 1994;50(3):23–33) to provide a model close to the market practice, easy to implement and fitting with Basel III framework. We approach the dependence between counterparty risk and that of the reference entity with a technical tool: the copula, in particular, the mixture one that combines common “extreme” copulas. We study the CDS's vulnerability in extreme dependence cases. By varying Spearman's rho, the mixture copula covers a broad spectrum of dependence and ensures closed form prices. We end up with an application on real market data.     

A real options approach for evaluating the implementation of a risk-sensitive capital rule in banks

I evaluate a bank's incentives to implement a risk-sensitive regulatory capital rule. The decision making is analyzed within a real options framework where optimal policies are derived in terms of threshold levels of credit risk. I provide a numerical example for the implementation of internal ratings based models for credit risk (the IRB approach) under the new Basel Accord (Basel II).     

Optimal capital growth with convex shortfall penalties

The optimal capital growth strategy or Kelly strategy has many desirable properties such as maximizing the asymptotic long-run growth of capital. However, it has considerable short-run risk since the utility is logarithmic, with essentially zero Arrow–Pratt risk aversion. It is common to control risk with a Value-at-Risk (VaR) constraint defined on the end of horizon wealth. A more effective approach is to impose a VaR constraint at each time on the wealth path. In this paper, we provide a method to obtain the maximum growth while staying above an ex-ante discrete time wealth path with high probability, where shortfalls below the path are penalized with a convex function of the shortfall. The effect of the path VaR condition and shortfall penalties is a lower growth rate than the Kelly strategy, but the downside risk is under control. The asset price dynamics are defined by a model with Markov transitions between several market regimes and geometric Brownian motion for prices within a regime. The stochastic investment model is reformulated as a deterministic programme which allows the calculation of the optimal constrained growth wagers at discrete points in time.     

Selecting credit rating models: a cross-validation-based comparison of discriminatory power

In commercial banking, various statistical models for corporate credit rating have been theoretically promoted and applied to bank-specific credit portfolios. In this paper, we empirically compare and test the performance of a wide range of parametric and nonparametric credit rating model approaches in a statistically coherent way, based on a ‘real-world’ data set. We repetitively (k times) split a large sample of industrial firms’ default data into disjoint training and validation subsamples. For all model types, we estimate k out-of-sample discriminatory power measures, allowing us to compare the models coherently. We observe that more complex and nonparametric approaches, such as random forest, neural networks, and generalized additive models, perform best in-sample. However, comparing k out-of-sample cross-validation results, these models overfit and lose some of their predictive power. Rather than improving discriminatory power, we perceive their major contribution to be their usefulness as diagnostic tools for the selection of rating factors and the development of simpler, parametric models.

The impact of imposing capital requirements on systemic risk

This paper examines the impact of imposing capital requirements on systemic risk. We use a static model on financial institutions’ risk-taking behavior to quantify the systemic risk in the cross-sectional dimension in both regulated and unregulated systems. Although imposing a capital requirement can lower individual risk, it simultaneously enhances systemic linkage within the system. By using a proper systemic risk measure combining both individual risk and systemic linkage, we show that systemic risk in a regulated system can be higher than that in an unregulated system. In addition, we analyze a sufficient condition under which the systemic risk in a regulated system is always lower.     

Modeling the business risk of financially weakened firms: A new approach for corporate bond pricing

Most structural models of default risk assume that the firm's asset return is normally distributed, with a constant volatility. By contrast, this article details the properties that the process of assets should have in the case of financially weakened firms. It points out that jump-diffusion processes with time-varying volatility provide a refined and accurate perspective on the business risk dimension of default risk. Representative Arrow-Debreu state price densities (SPD) and term structures of credit spreads are then explored. The credit curves show that the business uncertainties play a major in the pricing of corporate liabilities.     

Counterparty Risk for Credit Default Swaps: Markov Chain Interacting Intensities Model with Stochastic Intensity

We analyze the counterparty risk for credit default swaps using the Markov chain model of portfolio credit risk of multiple obligors with interacting default intensity processes. The default correlation between the protection seller and underlying entity is modeled by an increment in default intensity upon the occurrence of an external shock event. The arrival of the shock event is a Cox process whose stochastic intensity is assumed to follow an affine diffusion process with jumps. We examine how the correlated default risks between the protection seller and the underlying entity may affect the credit default premium in a credit default swap.     

Financial networks and systemic risk vulnerabilities: A tale of Indian banks

This study identifies the nature and direction of unprecedented upheavals in the Indian banking sector which is linked to credit market asymmetry. A tail-driven network approach with a mixed sample of banks and firms exhibits the characteristics of the twin-balance-sheet syndrome. We construct the networks with a degree of interconnectedness at different quantiles and identify major systemic risk emitters and receivers. Furthermore, we find a spillover of the riskiness of deep-in-debt firms to banks. Smaller banking institutions evince a greater connection to banks and firms than larger ones. Our results are valuable for policymakers formulating financial stabilization policies and investors considering Indian markets for various opportunities.     

The impact of the choice of VaR models on the level of regulatory capital according to Basel II

The Basel II framework allows the calculation of the capital requirements for market risk with Value-at-Risk models. Since no special model is prescribed in the framework, banks may use simple models with questionable assumptions concerning their underlying distributions. Our numerical analysis reveals that simple VaR models that perform noticeably worse than comparable simple models with more realistic assumptions may lead to a lower level of regulatory capital for banks. For this reason, banks have a major incentive to implement bad models. This is obviously contrary to the interests of regulatory authorities.     

预期信用损失模型对银行资本计提的结构性影响研究——基于50家上市商业银行的实证分析

预期信用损失模型是一项新的贷款损失准备计提方法,对其经济后果的评估非常重要.关于预期信用损失模型的实施对我国商业银行资本计提的具体影响,目前还缺乏深入系统的研究.本文结合我国50家上市商业银行的公开数据,从监管资本、会计损益和资本计提前瞻性的角度分析了预期信用损失模型对我国商业银行资本计提的影响.研究结果表明:总体影响上,商业银行的贷款损失准备计提金额显著增加,利润波动增强,对资本充足率带来一定冲击;从不同特征商业银行看,小型商业银行、使用权重法商业银行、城市商业银行和H股上市商业银行受到的影响更为严重;从资本计提的前瞻性看,贷款损失准备的前瞻性得到加强,顺周期性效应得到一定程度缓解,但并不能完全消除.     

Transitional credit modelling and its relationship to market value at risk: an Australian sectoral perspective

Internal credit risk modelling is important for banks for the calculation of capital adequacy in terms of the Basel Accords, and for the management of sectoral exposure. We examine Credit Value at Risk (VaR), Conditional Credit Value at Risk (Credit CVaR) and the relationship between market and credit risk. Significant association is found between different Credit CVaR methods, and between market and credit risk. Simpler Credit CVaR methods are found to be viable alternatives to more complex methodology. The relationship between market and credit risk is used to develop a new model that allows banks to incorporate industry risk into transition modelling, without macroeconomic analysis.     

Assessing targeted macroprudential financial regulation: The case of the 2006 commercial real estate guidance for banks

In January 2006, federal regulators issued guidance requiring banks with specific high concentrations of commercial real estate (CRE) loans to tighten managerial controls. This paper shows that banks with concentrations in excess of the thresholds set in the guidance subsequently experienced slower growth in their CRE portfolios than can be explained by changes in bank or economic conditions. Moreover, banks above the CRE thresholds tended to have slower commercial and industrial loan growth but faster household loan growth following issuance of the guidance. The results highlight the potentially broad influence that portfolio-based macroprudential regulation might have on bank behavior.     

The impact of bank regulation on the cost of credit: Evidence from a discontinuity in capital requirements

We study the effect on credit relationships of the Small and Medium Enterprises Supporting Factor (SME-SF), a regulatory risk weight reduction on small loans to SMEs. Employing a regression discontinuity design and matched bank-firm data from Italy, we find that a 1 percent drop in capital requirements causes an average 13 basis points reduction in the cost of credit. Moreover, with a novel measure of bank regulatory capital scarcity, we show that the drop is larger for banks facing tighter constraints. Furthermore, the drop is larger for firms with low switching costs, while the sharp assignment rule may have led to the rationing of marginal borrowers. Such findings indicate that the entire distribution of firms and banks’ characteristics plays a crucial role in determining the impact of regulatory capital changes.     

Modelling portfolio capital flows in a global framework: Multilateral implications of capital controls

In the aftermath of the global financial crisis, many emerging market countries resorted to capital controls to tackle the excessive surge of capital inflows. A number of recent research papers have suggested that the imposition of controls may have imposed negative externalities on other countries by deflecting flows. Our aim in the research reported in this paper is to assess the efficacy of capital controls and potential deflection effects on other countries by constructing a comprehensive global econometric model which captures the dynamic interactions of capital flows with domestic and global fundamentals. The results suggest that capital controls are effective for some countries in the short run, but have no lasting effects. Moreover, there is only limited evidence of deflection effects for a small number of emerging market countries.     

Liquidity risk in derivatives valuation: an improved credit proxy method

The models used to calculate post-crisis valuation adjustments, market risk and capital measures for derivatives are subject to liquidity risk due to severe lack of available information to obtain market implied model parameters. The European Banking Authority has proposed an intersection methodology to calculate a proxy CDS or Bond spread. Due to practical issues of this method, Chourdakis et al. introduce a cross-section approach. In this paper, we extend the cross-section methodology using equity returns, and show that our methodology is significantly more accurate compared to both existing methodologies, and produces more reliable, stable and robust market risk and capital measures, and credit valuation adjustment.     

Leaving the darkness: The emergence of shadow banks

This paper studies the interaction between bank capital regulation, moral hazard and co-existence of traditional and shadow banks. Bank managers can choose between traditional banking and off-balance sheet special purpose vehicles (SPV), in a setup with deposit insurance and moral hazard. We first show that in the absence of SPV intermediation, capital requirements are ineffective at preventing the moral hazard problem originated by deposit insurance. We find that shadow banks can improve financial stability, when there is full information sharing. Finally, we analyze the case of neglected tail risk. We find that under such circumstances, the SPV will increase financial risk by exposing the system to extreme events.